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Wednesday, March 5, 2014

The Gold Standard Was an Accident of History

I recently reviewed Lewis E. Lehrman's book, Money, Gold, and History for the National Review. This book is a compilation of his essays where he calls for a return to an international gold standard. He takes a very sanguine view of its history and how it would work today. Though the classical gold standard of 1870-1914 did work relatively well, the history of gold as money is far more nuanced than portrayed by Lehrman. Here is an excerpt of my review where I touch on this point:

Consider, first, the history of the gold standard. Though Lehrman claims that the gold standard is “the historic common currency of civilization” and the “proven guarantor of one hundred years of price stability,” the history of gold is far more nuanced. Silver actually was the dominant metallic standard for hundreds of years before gold. The main reason it was displaced by gold is not that gold was inherently better, but that important countries, including the U.K. and the U.S., introduced bimetallism—legally minting silver and gold into money—and did so at exchange rates that inadvertently led to the undervaluation of silver. This undervaluation eventually drove silver out of circulation as money. Gold became the money standard largely by accident.

In the U.S., bimetallism was introduced in 1792. Soon afterward, changing market prices led to an overvaluation of silver at the mint and a de facto silver standard that lasted until 1834. Congress then changed the mint ratio and, in an instant, gold became overvalued, and would serve as the monetary standard from 1834 to 1861. This change was part of President Andrew Jackson’s famous war on the Second Bank of the United States, whose bills were backed by silver. There was nothing market-driven or natural about this switch from a silver standard to a gold standard. It was pure politics.

That gold was an accident of history is further evident in the contentious debate over a gold standard versus a bimetallic standard after the Civil War. Convertibility of dollars into metals had ended with the Civil War, and Congress had set 1879 as the year it would resume. Congress, however, failed to authorize the further coinage of silver. This meant that dollars would be convertible only into gold. Had silver still been coined at the mint, it would have become, by 1879, the de facto money standard, given market prices. This shift to gold irritated many, particularly those who thought gold was too deflationary; this was such a concern that it became the defining issue of the 1896 presidential election. Only with the Gold Standard Act of 1900 was the possibility of monetizing silver permanently put to rest. If gold was the “currency of civilization” for centuries, as Lehrman claims, why was its success an accident, and why has the U.S. money standard always been so contentious?

Lehrman also claims that politicians cannot manipulate a gold standard as they can fiat currency, because the gold supply depends on real-world gold production. But the above examples and others (such as the suspension of convertibility during the Civil War and FDR’s confiscation of gold in 1933) clearly show that even the gold standard is susceptible to manipulation.

That the U.S. gold standard was an accident of history and that its longest unchallenged, continuous run was only a quarter of a century suggests the question: Was it was the gold standard, per se, that created the long-run price stability of the 18th and 19th centuries, or was it a deeper political and institutional commitment to price stability?

I go on to make the case that it is not price stability per se we want, but monetary stability. I argue that is best accomplished by stabilizing the expected path of total dollar spending growth. You can read the rest of my review here.

"In short, there is a really serious problem inherent in any banking system in which the standard is itself a medium of exchange. The very fact that gold is money means that, in any fractional reserve system based on gold, there is an inherent tendency for the system to implode when there is a loss of confidence in bank money that causes a shift in demand from bank money to gold. In principle, what would be most desirable is a system in which the monetary standard is not itself money. Alternatively, the monetary standard could be an asset whose supply may be increased without limit to meet an increase in demand, an asset like, you guessed it, Federal Reserve notes and reserves. But that very defect is precisely what makes the Ron Pauls of this world think that the gold standard is such a wonderful idea. And that is a scary — as in terrifying — thought."

Well I am no gold bug and I agree that monetary policy is much better effected under a NGDP LT type regime, but I don't agree that protection against bank runs is a reason to argue against a gold standard, in fact it may be an argument for one as the chance of moral hazard is less in that case. If we had banks more obviously exposed to bank runs, perhaps they would be run more conservatively as a result of market or regulator pressure. Some people argue under this basis supply of credit would be too low, and this would slow economic growth, but I believe that economic growth is actually driven by technology advances not credit supply. For instance can anyone show higher growth in countries with laser banking regulations allowing more leverage?

We tried that thought-experiment during the Hoover administration. The money supply and the price level collapsed. Yes, banks experienced market discipline, as did millions of formerly-employed workers. The result was socialism. Let's not try that again.

China went to a silver standard 700 years ago (although silver ingots were popularly used even 1000 years ago) and basically stuck with silver until the Great Depression. Indeed, the Chinese word for bank for bank is something like "silver house."

But as for stability, the two metals, silver and gold, are not even stable to each other.

Surely there are problems with central banking and fiat money. The current monomania regarding inflation is one example, and it afflicts central bankers even more than some economists.

But with a gold standard, there is the possibility of cascading disintermediation, and no lender of last resort to re-capitalize banks that fail---resulting in even more furious bank runs. Add in Murphy's Law, and it will happen one day, with a gold standard.

People forget, in pure free markets savers can lose all their money, as well as have returns. The idea that savers are entitled to a return is a modern, and state-subsidized fiction.

Indeed, as far as I can tell, the only way to assure savers get a return is a government-backed TIPS bond, or bank deposit insurance backed by a central bank, and with an artificially rigged and high interest rate. Hardly free markets.

Tom Brown. There is a metal alloy known as "electrum." A mix of silver and gold, sometimes naturally occurring.

God's way of showing us to go to the "electrum standard."

Moreover, it has lineage.

"Electrum was used for the earliest metal coins, and as early as the third millennium BC in Old Kingdom Egypt, sometimes as an exterior coating to the pyramidions atop ancient Egyptian pyramids and obelisks. Electrum was also used in the making of ancient drinking vessels. For several decades the medals awarded with the Nobel Prize have been made of gold-plated green gold."

So, if the gold standard has history on its side, then electrum has even more.

My thesis: growth and price stability can coexist in a free market economy such as the late 19th century, when we had both deflation and growth. They cannot coexist in a socialist environment where wages and prices are sticky--unless pursued to the point where wages and prices become unstuck. We can return to a 19th century economy if we are prepared to go through another Great Depression without a New Deal at the end. This is what the ECB is trying to do now: force wage and price flexibility on Europe by imposing price stability in the face of depression. A noble experiment if you don't care about people.

Interestingly, despite Great Britain's famous commitment to the gold standard in the late 19th/early 20th centuries, for much of their history the countries of the UK were actually on a grain standard. Grain standards are not often talked about but they are surprisingly common. In agrarian societies it makes a fair amount of sense to tie the currency to the principal food staple. If you don't, a bad harvest causes inflation as well as unemployment - double misery for your population.

During the prime years of the gold standard favored by the gold bugs the gold market was not a free market.

Rather,the federal government and/or the Bank of England imposed a price for gold that was above the market clearing price. They stood ready to buy all gold tendered to it at the official price.and during that period accumulated large stocks of gold. Their accumulating gold stocks demonstrated that their price was above the market clearing price. If their price had been below the market clearing price they would have sold off their gold stocks, as they did in the 1960s when $35 gold was blow the market clearing price.

Thus the gold standard was not at all a free market. Rather it was a market completely dependent on government intervention.